5. The Federal Reserve System was crated in 1913. The Fed
is owned by the member banks. The owners get only small divides, but do
not control its operation. Federal Reserve Board of Governors is appointed
by the president. However, it is almost impossible for the present to influence
the policies of the Fed.

How the Fed Changes Money Supply

The Fed has 3 major methods by which to control the money
supply.

Open Market Operations

This involves buying and selling of government
bonds by the Fed. This is the most important: (i) it can be implemented
quickly and cheaply. The fed calls an agent who buys and sells bonds.

(ii) it can be done quietly when desired. Sometimes
the Fed does not want to announce it publicly. (iii) The Fed can choose
the quantity, small or large.

Suppose the reserve requirement is 10%. When the
Fed buys a $1 million bond, initially deposit in a commercial bank
increases by the same amount. However, since the reserve requirement
is 10%, the entire banking system can lend $9 million, which results
in a $9 million deposit. Thus, the money supply can increase up to
$10 million.

Reserve Requirement

This tool is not frequently used, but is potentially
powerful. If the required reserve ratio is raised to 15%, the sale
of $1 million bond can increase money supply by $1 million/.15 = $6.7
million only. Thus, a change in the reserve requirement can significantly
affect the money supply.

Frequent changes in RR make it difficult for banks
to plan. It is like using a sledgehammer to kill a mosquito. In the
1970s, RR was changed twice, each time less than 1%.

If the Fed buys a bond for $1 billion, and RR = 10%,
the potential money supply increase by $10 billion. If RR =12%, this
amount reduces to $1/.12 = $8.3 billion. Thus, a small change in RR
causes a big change in the potential money supply.

For this reason, RR changes are not used frequently.

Discount Rate

Banks that have trouble meeting their
reserve requirement can borrow funds directly from the Fed at its
discout window. Discount rate is the interest rate that the Fed charges
to banks.

If the Fed wants to expand money supply, it lowers
the discount rate. Sometimes the discount rate is changed several
times a year.

The discount window is not used often, except in
emergencies by the banks. In the stock market crash of 2008, the Fed
provided loans to many financial institutions.

When banks needd short term loans, they tend to use
the Federal Funds Market.

Difficulties in Controlling the Money Supply

It is difficult for the Fed to control the exact amount
of money supply for two reasons.

unpredictability of deposit

The more people put cash in the banks, the more excess
reserves the banking system has. As a result, more money is lent and more
deposits are created.

During a financial crisis, people are worried about the
health of the system and withdraw money. The more money they withdraw
from the banking system, the less money is created.

loans

When banks keep excess reserves they lend less to the
public. The banks create less loan and money than the Fed desires. Accordingly,
the Fed has less control.

Coordination of Fiscal and Monetary Policies

(i) Congress and the President make fiscal policy decisions.

(ii) The Fed makes monetary policy decisions.

The chairman of the Fed often participates in meetings with
the President's staff. Through this process they try to reach a consensus. Some
argue that this is dangerous and that the Fed should be completely independent
of the executive branch, because the monetary policy might be used by the executive
branch to reelect the incumbent.

Timing of monetary and fiscal policies

Initially, the economy has unemployment at point A. Even without
any policy intervention, the economy will eventually reach point B. However,
sometimes impatient policy makers want a quick fix and employ an expansionary
fiscal or monetary policy, thereby overshooting the desired goal. AD curve shifts
to AD", which causes inflation. As producers raise prices, AS shifts upward,
and the economy eventually reach point F. The long run consequence is inflation
and budget deficit, without any long term effects on output.

Money Market

Real money balances (M/P) measure the purchasing power of
a given money stock. A nation's nominal GDP is written as PY. If money is needed
to faciliate economic transactions, money demand needed is proportional to nominal
GDP, i.e.,

Md= kPY,

where k is a positive constant. If the money market is in equilibrium,
money demand must be equal to money supply M. Thus, the above relation can be
written as

M(1/k) = PY or

MV = PY,

where V is velocity of money.

If we assume that the velocity of money is constant, then the
quantity equation becomes a useful theory, the Quantity Theory of Money.

Constant Velocity of Money

Velocity changes when consumer habits of spending money changes.
When credit cards were invented, people no longer needed to carry large amounts
of cash in person, and money demand declined and its velocity change declined
as well.

Velocity of money is fixed, but can be changed in response
to technological changes of handling money.

That is, when money supply increases, either price or output
must increase by the same proportion. In the Keynsian economy with substantial
unemployment, price is fixed. Thus, an increase in money supply will raise real
output proportionately. On the other hand, in a full employment economy, no
output can be changed. Thus, a 10% increase in money supply will increase the
price level by the same proportion. However, consumers may hold money for other
purposes.

Economists thought that velocity of money was constant. Velocity
of money has been stable over a long period of time, when M2 definition is used.

Velocity of money is not constant, and often varies in a predictable
way when new financial instruments are introduced (such as credit cards).

Why do countries allow the money supply to outpace real output?
Due to war and political instability, a country's spending may exceed the amount
of tax it collects. In this case, the government often print more money to pay
bills. The more money they print, the higher infaltion they experience.

Hyperinflation

When there is rapid inflation, it is called hyperinflation.
A famous exmaple is the hyperinflation in Germany. Inflation rate rose to roughly
300% per month. German government incurred a huget debt (war reparation payment)
after WWI. Firms had to pay workers several times a week. Stores changed prices
in the middle of the day. In this case, money stops being efficient in its role
as the medium of exchange. Barter exchange flourishes instead.

German Hyperinflation

Foward markets do not operate
during periods of hyperinflation. Because inflation rates accelerate at an unknown
rate, even speculators stay away from such currencies. Inflation rates differ
amont countries due to differences in monetary and fiscal policies. Single currency
in Europe means member countries cannot conduct their own monetary policies,
i.e., they cannot increase money supply independently because it is the European
Central Bank that controls the money supply. However, freedom is useful only
when discretion is exercised. Just look at what happened to Germany after World
War I.

(World War I, or the Great War, ended on November 11, 1918.
The Versailles
Treaty was signed on January 12, 1919 and Germany promised to pay war reparation
payment of £6.6 billion.) The value of money can be totally undermined
when the government prints so many pieces of paper currency. High inflation
rate causes a capital flight. When the inflation rate was 6000% per year, it
caused a dramatic capital flight. Workers converted their money into other stable
currencies. As a result, stores refused to sell goods, and citizens looted many
stores.

The infamous post-World War I inflation in Germany is a good
example. In December 1919 there were about 50 billion marks in circulation in
Germany. Exactly four years later, this figure expanded to 497 quintillion (497,000,000,000,000,000,000)
marks. That is, the money supply increased 10 billion times.

From August 1922 to November
1923, inflation averaged 322 percent per month. Prices at the end of that German
hyperinflation (i.e., particularly high inflation) were 10 billion times the
original level. (Someone who lived through hyperinflation defined it as follows:
hyperinflation is when it is cheaper to pay for your lunch before you start
eating it than after you finish).

In October 1923, the prices
increased 100 times. In October 15, 1923, a monetary reform was announced, a
new unit of currency called Rentenmark replaced the old currency Reichsmark.
One unit of the new currency was set equal to 1 trillion units of the old currency.
A new bank was established to take over the function of note issue.

Excerpt from a book (lost the source).

It was Germany, 1923,
and times were hard. Inflation over the past 3 years had driven prices to very
high levels. Ferdinand Porsche, the carmaker, needed cash.

Porsche had received three
luxury cars as partial compensation when he left Austro- Daimler. The three
cars, called City Coaches, were elaborate creations. In front they offered open
seats for the chauffeurs and passengers. Behind these were two more open seats
with a movable cover in case of rain, and at the rear was a closed compartment
for passengers for use in case of severe weather. The manufacturer boasted that
the city Coach combined the best features of an open car, a convertible, and
a limousine. Porsche approached a friend in Stuttgart, business executive Alfred
Neubauer. He found a buyer in Backnang for one of these cars. He recalled later
that Mr. Porsche was delighted with the price, which was in the millions of
marks.

The car was delivered to
the buyer. One week later the money reached Stuttgart. During that week, however,
the pace of inflation had accelerated. Porsche had sold one of the grandest
vehicles in the worldžbut by the time he got the money, it was just enough to
pay for six rides on the local streetcar line.

Difficulty of Controling Money Supply

The Role of Commercial Banks

One problem with the monetary policy is
that it must be carried out through the commercial banks. The central
bank can only change the environement in which commercial banks live,
but it is the banks that must extend loans and create money. As the saying
goes, you can lead a horse to water but you can't make it drink!

When the Fed wants to contract money supply, it has no
trouble forcing the banks to comply. Why?

The banks must meet reserve requirements. If the Fed
raises RR, then banks must sell bonds and other securities to increase
its deposits with the Fed. In the process, the banks decrease loans and
money supply.

When the Fed wants to increase money supply, it can decrease
RR, which means the banks have excess reserves. They can increase loans,
but they may not. During boom periods, the banks want to convert the excess
reserves into other assets by making loans. However, in a recession, banks
may be reluctant to extend loans. During the Great Depression, banks did
not loan out these excess reserves.

In 1935, when discussing the Banking Act of 1935,

Congressman Thomas Goldsborough: You mean you cannot
push a string.

Governor (of the Fed) Marriner Eccles: That is a good
way to put it, one cannot push a string.

Nonbank Institutions

Pension funds and insurance companies make loans, but
are not subject to RR. They can alter the impact of Fed's policy.

Coordination Problem

Fiscal policies are made by the executive branch, while
monetary policy is made by the Fed. They may have conflicting goals, and
may not agree on policy goals. The government may argue that unemployment
is the urgent problem, while the Fed may be more concerned with inflation.

John Maynard Keynes argued that there are three components
in the demand for money.

(i) Transactions Demand

Money is required to facilitate economic transactions, i.e., to pay bills.
Other securities are not readily accepted. Transactions demand increases
with the volume of economic transactions or output. Individuals and firms
may hold money for transactions purposes, but this transactions balance
may depend on the interest rate. Firms may try to economize the transactions
balance, but Keynes thought that the tranasctions balance would be insensitive
to changes in the interest rate.

(ii) Precautionary Demand

Individuals need cash to meet emergencies – medical emergencies,
unemployment or repairs. Precautionary demand for money increases with
income. To simplify the analysis, we can treat precautionary demand for
money as unexpected transactions demand for money, and assume that it
is insensitive to changes in the interest rate.

(iii) Speculative Demand

Keynes argued that firms and individuals hold some money for speculative
purposes, to take advantage of profitable investment opportunities.

He argued that given uncertainties, speculative balance is inversely
related to the interest rate.

We use the modern approach and assume money demand has
two components.

Transations demand for money is proportional to income,
and hence can be expressed as k(Y+) = kPy. Transactions are always
in current prices (Py). Precautionary demand for money is included in the
transactions balance. Speculative demand is inversely related to interest
rate, and denoted by L(r¯).

two components: (Nominal) Money demand = L(r¯) +
kPy

(Real) Money demand = ℓ(r¯) + ky, k > 0.

Money market equilibrium requires:

Ms/P = ℓ(r¯) + ky

Money Supply

Money supply is largely governed by the central bank, and
the quantity is periodically adjusted. It is considered to be vertical, independent
of the market interest rate.

Money Market Equilibrium

Control Money Supply or Interest Rate

Some economists argue that the Fed should control money
supply, while others contend that interest rate should be controled. Obviously,
the Fed cannot do both, given the negative slope of the money demand curve.
Suppose income increases. If money supply is controlled, this would result
in an increase in the interest rate. If the Fed desires to maintain a stable
interest rate, it must increase money supply.

Problem

The problem with targeting money supply is that the demand
for money fluctuates considerably in the short run. When money supply is targeted,
random fluctuations in money demand caused large variations in the interest
rates durig the 1970s and 80s. These erratic changes can seriously disput the
economy.

Interest rate targeting also creates problems. When the economy
grows, money demand also grows. In order to maintain stable interest rate, money
supply has to increase. Expanding money supply during the boom period is inflationary.
Likewise, conracting money supply during recession will make the recession even
worse. However, since the 1980s, the Fed switched to the interest rate targeting
policy.

Which interest rate?

The Fed targets the federal funds rate, which is the interest
rate that banks charge each other for short term loans. A bank that is short
of reserves may borrow from another that has excess reserves.

Classical economists assumed that economies would operate at
full employment because prices and wages are flexible. If unemployment were
present, wages and prices would fall until full employment was restored. The
classical economists wrote in the 19th century. Empirical evidence shows that
prices were indeed flexible during that period. Extreme upward and downward
movements in prices took place regularly. This was due to the greater importance
of agriculture in the 19th century. Agricultural prices were flexible in both
directions.

An increase in the real interest lowers the speculative balance, which must
be offset by an increase in the tranactions balance, and hence real income
must increase. There is a positive relationship between interest rate r and
real income y that must be maintained in order to clear the money market.
This relationship is called the LM curve (Liquidity-Money)

When both IS and LM intersect each other, both markets are
in equilibrium.

Changes in Money Supply

Δ Ms/P = ℓ(r¯) + ky

For given output, an increase in money supply must be matched
by an increase in the speculative demand for money, and hence the interest
rate must be lowered. Thus, an increase in money supply shifts the LM curve
to the right.

In recent years, there has been inventions of money substitutes
such as credit cards and automated teller machines (ATMs), which reduce the
need for cash. These changes also shift the LM curve to the right.

The Effect of Fiscal Expansion

Consider an increase in government spending by $1 trillion,
which shifts the IS curve to the right. What is its economic impact?

Effects of monetary and fiscal policies depend on the shapes
and slopes of IS and LM curves. In some cases, the LM curve may have a flag
segment. For instance, the interest rate has been zero for about five years
during this decade. Any further increase in money supply cannot lower the
interest rate beyond a certain level, if most consumers believe that the interest
rate will rise soon. Keynes called this liquidity trap. Any further increase
in money supply will be absorbed as savings without affecting the output level.
(The speculative demand increases.) A monetary expansion only shifts the LM
curve to LM' without affecting the interest rate and output.

A political business occurs if the central bank cooperates with the incumbent
party and pursue an expansionary monetary policy before an election.

Short Run

Increased output

Reduced unemployment

Incumbent party wins

Long Run

inflation

Some economists argue that the central banks should adopt rules such as maintaining
a constant growth of 3-5%, to faciliate economic growth. If the desired economic
growth rate is 3% per year, the monetary growth rate should also be 3%. In
this case, the average inflation rate is zero. However, this goal is unrealistic,
because in most countries the inflation rates are positive.

Inflation Targeting

Proponents

Some economists argue that we should target the inflation rate. This
means the central bank needs to regulate the inflation rate within a
narrow band, say between 2 and 3 %. Such targeting stabilizes inflationary
expectation.

Bank of England: 2%

Bank of Canada: 2%

Bank of Brazil: 4.5%

Chile: 2-4%.

Empirical evidence suggests that those countries with inflation targets
tend to have stable inflation rates.

Zero inflation target could lead to deflation (falling
prices) as in Japan in the 1990s. In Japan the interest rate has been
zero for several years. In this situation, expansionary policy is difficult
to implement (as the interest rate is zero already.)

The Fed needs flexibility to couter disorderly conditions.
The Fed made huge loans to avoid a financial crisis after September
11, 2001.

The cost of zero inflation rate is too high. It risks
deflation. A 1% reduction in the inflation rate may be 3-% loss in output.

Taylor Rule

Taylor Rule is a hybrid, part rule, part discretion proposed by John Taylor
in 1993: That the nominal interest should rate should change in response to
the divergences of actual inflation rate and GDP from the target levels.

John Taylor emphasized that if inflation rate were to rise by 1%, the proper
response would be to raise the interest rate by 1.5% (that is, .5 % above
the inflation rate). If GDP falls by 1% below the growth path, interest rate
could be cut by .5%.

During the Greenspan period, the Fed's policy more or less followed this
rule unknowingly.